A Utility’s use of Financial Products

1. A Utility’s use of Financial Products February 6, 2012

2. Derivative(Financial Product) • A security whose price is dependent upon or derived from one or more underlying assets. • A contract between two or more parties • Common underlying assets • Stocks • Bonds • Commodities • Currencies • Interest rates • Market indexes Reference: Investopedia.com

3. Three Basic Uses of Derivatives • Speculation • Attempts to make money based on predicted moves in the market • Arbitrage • Arbitrage occurs when an investor can take a position for no cost, with no risk, and make a positive profit • Hedging • Goal is Risk Minimization • Company or individual already has a position in the market and uses forwards, futures, options, to minimize risk

4. Arbitrage • Interstate Natural Gas Pipeline Capacity • Locational spread • Purchase in location “A” transport and sell in location “B” • Natural Gas Underground Storage • Time spread • Purchase in time period “A” hold in storage and sell in time period “B” • Power generator • Tolling (spark spread) • Purchase fuel and sell power • Refinery • Refining Spread (Crack spread) • Purchase crude oil and sell refined products (heating oil, gasoline, jet fuel)

5. Effective Use of Derivatives • First determine what are the risks. • Are the risks quantifiable? • timing and amount • Make sure the hedge matches your risk or that you understand when and where it doesn’t match your risk. • Shift risk to other market participants • What are the costs to execute the hedge?

6. Futures vs. OTC • New York Mercantile Exchange (NYMEX) • Standardized natural gas futures and options contracts • 10,000 dt per contract • Priced for purchase or delivery at Henry Hub, LA • No credit exposure; post margins • Trade via Introducing Broker or directly with the floor • Settled monthly on third to last business day • Over-the-Counter • Terms customized to individual customer needs • Counterparty credit exposure • Bilateral ISDA master agreements

7. Basic Financial Instruments • Swaps, (Fixed price, Futures) • A swap is an obligation on both parties’ part • Options • Puts (Floor) • Calls (Ceiling or cap) • An option is a right, but not an obligation for one party (buyer); and an obligation for the other party (seller) • Options are price insurance • Premiums are paid to purchase insurance

8. Financial Products • Input graph of various derivative %

9. Absolute Price Risk • Reduce price volatility • Residential heating and electric customers • Budget • Certainty to future costs • Maintain competitiveness • Airlines • Fertilizer manufacturers

10. Why use financial products? • Standardized contracts • Market liquidity • Disconnect price from physical delivery • Better pricing

11. Physical to Financial Correlation • Input gas slide

12. On October 27th: Market is at $8.00 $8.00 $8.00 $6.00 $6.00 $/dt $4.00 $2.00 $2.00 $- Physical Financial Net Market at $4.00 $8.00 $6.00 $6.00 $4.00 $4.00 $/dt $5.00 $- Physical Financial Net $(2.00) $(2.00) Hedge Example with Swap • Results • Protected against adverse price movement • Removed volatility from price • Buy a November 2012 swap contract • for $6.00 settled against index. • Utility purchases gas from producers for delivery in November at index.

13. Counter-party Pay Fix Price Receive Floating Price (NYMEX last day) Receive Physical Gas Gas Producer/ Supplier Utility Pay Floating Price (Index Price) Natural Gas Physical and Financial Settlement -$6.00 +$8.00 -$8.00

14. Swaps vs. Options • Buying swaps commits you to fixed price • Options give the buyer price security and also the benefit of potentially more favorable prices in the future. • The party buying the insurance pays a premium because they receive something of value. • Examples • Calls are purchased to have the right to pay a fixed price but not the obligation. (Consumer calls) • Puts are purchased to have the right to receive a fixed price but not the obligation. (Producer puts)

15. Option Terminology • Strike Price - the price beyond which the buyer of the option benefits • Premium - what the buyer pays for the option • Pay off - the benefit received by the option buyer • Difference between strike and settled price Note: The customer may specify either the strike price or the premium. Once you know one, the other is calculated based upon market levels.

16. Types of Option Settlements • Options should match the physical and pricing aspects of your portfolio • European – exercised only on the expiration date itself • American – exercised any time up to the expiration date • Asian – average price options

17. On October 27th, Market is at $8.00 $8.00 $8.00 $6.80 $6.00 $/dt $4.00 $2.00 less $0.80 $2.00 $- Physical Financial Net Market at $4.00 $8.00 $4.80 $6.00 $4.00 $4.00 $/dt $5.00 $- Physical Financial Net $(1.00) $(0.80) Hedge Example with Call • Results • Protected against price spike • Participate in downward price moves. • Buy November 2012 $6.00 Call option for $0.80 premium, settled against NYMEX last day (index). • Utility purchases gas from producers for delivery in November at index.

18. On October 27th, Market is at $8.00 $8.00 $8.00 $6.50 $6.00 $/dt $4.00 $2.00 less $0.50 $2.00 $- Physical Financial Net Market at $4.00 Market at $5.25 $8.00 $8.00 $5.75 $5.50 $6.00 $6.00 $5.25 $4.00 $4.00 $4.00 $/dt $/dt $5.00 $5.00 $- $- Physical Physical Financial Financial Net Net $(1.50) $(0.50) Loss of $1.00 plus $0.50 Loss of $0.50 Hedge Example with Collar • Buy November 2012 Collar: buy a $6.00 Call option and sell a $5.00 Put for $0.50 premium. • Utility purchases gas from producers for delivery in November at index. • Results • - Protected against price spike • - Set floor price.

19. Power Generation - Spark Spread • A spark spread is the price difference between the fuel cost input and market price for electricity. • Example • Sell July power for $50/MWh • Hedge $4/MMbtu natural gas fuel for July 2012, converted to $40/MWh* Power price $50/MWh Fuel price $40/MWh Spark Spread $10/MWh * Assumed heat rate of 10,000 Btu’s per MWh

20. Crude Oil Prices

21. Brent/WTI Spread

22. Dodd Frank Impact to Energy Industry • No impact to exchange traded transactions executed on NYMEX • Creation of swap repository • Clear all transactions • Margin requirements • Real time reporting • Increased recordkeeping • Market participants to registration with CFTC • End user exemption • Provide financial security documentation • Guarantee, LOC, credit support agreement, pledged asset • Establish position limits